The 17th and 18th centuries saw financial innovations whose creations have direct heirs today, from the modern deposit bank to the joint-stock company. However, it would be incorrect to imply that these institutions were the first of their kind. When it comes to banking for example, older Renaissance-era institutions made substantial breakthroughs and while that era’s banks were very different from those of later centuries, some of their innovations are still in use today.
Quite a few of these financial inventions came from the prominent Medici banking family in Florence. In fact, some of their most profitable financial creations were invented as a way of bypassing the period’s prohibitions on lending money at interest. These creations, such as the bill of exchange and the letter of credit still exist today, the latter does so in surprisingly similar form to how the Medicis’ used them centuries ago. Despite all the differences between banking in 15th century Florence and that of 17th century London and today, the banks of Renaissance Florence, and the Medici Bank in particular, helped invent modern finance.
Florentine Banking
To see just how different yet transformative they were, it is worth noting what banks in Renaissance Florence were like and in particularly how they differed from those of today. To start, most of the bank-like institutions of that time in Florence were not depository institutions. Most lending was done by individuals using their own capital, lending against physical collateral they would take possession of, much like a pawnshop. Although, in this respect the Medici Bank was exceptional for its time; it did take deposits. In fact, one of their largest depositors was the Catholic Church, rather curiously given its prohibition on usury, which in those days referred to the lending of money at any interest rate, not just an excessive rate.
The prohibition on usury obviously meant that many of these pawnbrokers operated beyond the law. Though operating very differently than the pawnshops, the Medici banking family still had to contend with laws that made their business a target of religious authorities. Part of the Medici Bank’s success resulted from creating ways to charge for their services without collecting interest in its typical form.
Lastly, it is important to note that the Medici Bank was not a bank for your ordinary person. It operated with large institutions, like the Church, or powerful or wealthy individuals, like monarchs and international merchants, in mind. If you were a commoner in need of money, you would not knock on the Medici family’s door to ask for a loan, but would rather borrow from the shadier pawnbrokers. In these respects, banking in 15th century Florence differed from the more modern banks of later centuries in cities like London and Amsterdam which served a wider clientele, took deposits, and did business in societies without prohibitions on usury.
Bills of Exchange
So how did the Medici Bank manage to maintain good relations with the Church despite being a bank in a time and place where lending at interest was banned? It did so by obscuring its interest charge behind other transactions, such as currency exchanges. One instrument for doing this was the bill of exchange.
Bills of exchange are contracts that normally guarantee payment of a pre-specified amount at some future date or on demand. Thus, a bank check is a type of bill of exchange and insofar as it is cashed after it is issued, it too is a kind of loan. To see how a bill of exchange can be structured as a loan, consider this: someone could obtain a loan by writing a bill of exchange and selling it to another party which could then redeem it at a set future date. Similarly, the buyer of a bill of exchange is essentially loaning money by paying now for the right to redeem the instrument later on. Though, the bills of exchange Florentine banks used always had pre-specified redemption dates, this is otherwise not too different than someone having a bank account today from which they then write checks. In the time between when money is deposited in the account and when the check is written, such transaction can be thought of as a loan to the bank. The Medicis used this instrument as a way of sidestepping usury laws by selling each bill of exchange in a currency different than the one it would pay out in.
Such a twist gave each contract an implicit exchange rate. Provided this rate was favorable to the bank relative to market rates, the bank could make a profit on the loan without charging conventional interest. As an example, suppose a Florentine merchant is looking for a loan to buy inventory to sell in Lyon. He could issue a bill of exchange to the Medici Bank in exchange for 100 florins to be repaid with 500 French livre in 90 days, by which point he would have sold his inventory in Lyon. Essentially, the bank would have made a loan and a currency exchange in one transaction. As long as the market exchange rate between the livre and the florin was less than 5:1, then the bank makes a profit. By making sure the implicit exchange rate in the transaction favored the bank, they would make a predictable profit and avoid charging interest, at least in its conventional form.
Letters of Credit
Another method of financing trade in this era was through a letter of credit. A commercial letter of credit was, and remains today, a means of guaranteeing payment to a seller of goods engaged in international trade. Essentially, an exporter operating internationally cannot always trust, or even assess the creditworthiness of, a purchaser from another country. To enable the trade nonetheless, the purchaser can buy a letter of credit from a bank to give to the seller as a guarantee that he will be paid. Skillful use of this financial instrument gave the Medici Bank a source of capital and a corresponding opportunity to deploy it and just like the bill of exchange, its profitability lie in exchange rates.
Suppose that our merchant in Florence was buying cloth from a seller in Lyon who demands his payment be guaranteed. In this era, sending money across the continent was a dangerous and costly proposition, so delivering physical cash was undesirable. Rather, the merchant could request a letter of credit and pay for it in florins. The letter of credit could then be sent to the seller who could cash it in livre at the Medici Bank’s branch in Lyon after a certain time elapses, say 90 days, and proof the product was shipped is provided. This sophisticated transaction involves the spatial, denominational, and intertemporal transformation of money. A sum in one currency in one place at one time is being transformed into a sum denominated in another currency and payable at another place at a later point in time.
To see how the Medici Bank profits in this, consider that when the Florentine merchant buys the letter of credit with florins and has it sent to the seller in Lyon, the Medici Bank obtained cash in florins and created a liability, payable in livre. Now imagine a merchant in Lyon with the opposite problem of our Florentine merchant; he needs to pay for a product in florins. He could buy a letter of credit paid for with livre and payable in florins in 90 days; after this second transaction, the Bank would essentially have two offsetting sets of assets and liabilities. Because each letter of credit involves setting an exchange rate, the bank could profit from the implicit spread between the florin-to-livre rate and the livre-to-florin rate each transaction was based on. This was the source of the bank’s returns on such a transaction.
Lesson
If the use of bills of exchange and letters of credit in 15th century Florence were merely to avoid confrontation with the religious authorities, then it would still be a lesson in human ingenuity. However, despite their complexity, these instruments actually met real world needs in an increasingly connected continent. Indeed, they weren’t even much more complex than the problems they solved. Exchanging a sum from one currency into another and having it paid at a specific time at a specific place is a challenge, especially in an era far removed from modern communication and financial know-how. Thus, while the Renaissance was primarily an era of artistic and philosophical rediscovery, it was also a period of burgeoning financial innovation, and institutions like the Medici Bank played a leading role in that innovation.
Further Reading
1. “3 Medici Banking Innovations We Still Use Today.” Edology.
2. “The Origin of Money 8 – Bills of Exchange and Banking.” The HipCrime Vocab, 17 Sept. 2017.
3. Parks, Tim. Medici Money: Banking, Metaphysics, and Art in Fifteenth-Century Florence. Profile Books, 2006.
4. Powers, Katherine A. “Rake in the Florins, the Medici Way!” Boston.com, The Boston Globe, 4 May 2008.
5. Roover, Raymond de. The Rise and Decline of the Medici Bank. Harvard University Press, 1968.
Lydia